The Hindu Business Line : Hidden costs of hedging

The articles on derivatives contracts by S. Gurumurthy (Business Line, July 4 and 5) clearly brought out the knowledge gap between the traders and their bankers. Exotic derivative products, when properly used, can decrease the risk associated with forex fluctuations. However, they tend to be very costly and are often designed in such a way that the transactions are more favorable to the banks than to their clients.

Before accusing the participatory banks of selling exotic derivatives, a number of questions need to be answered by the exporters to ensure they were on the same wave-length with the bankers. The following questions will seek answers from the exporters and figure out if they made a mistake in buying into these derivative products.

(1) Are the derivative tools used custom made or exchange traded? Is the tool

option based or futures based?

(2) Was it a deliverable or non-deliverable forward contract? If so, how was it constructed?

(3) What period did the contract cover?

(4) How much risk premium was collected in terms of basis points?

(5) Was the cost explicit or implicit with conditions attached?

(6) What was the value at risk?

(7) Was the entire expected A/R hedged?

(8) Did the derivative or forward contract cover the period of inflow or a much longer period? (Too much and too long covers are expensive.)

(9) What type of margins were required to be maintained with the bank to enter this contract? If the margin money was borrowed, what interest rate was charged?

(10) Was investigation of worthiness of hedging vis-À-vis cost done properly?

(risk-return analysis).

(12) If the bank itself was not the market-maker, how many banks were involved in each hedging?

(13) Hedging can be viewed as a zero sum game. Did the exporters always lose money?

(14) Did the banks explain the functions of the forex market, settlement procedures, etc?

(15) Was the hedging done in panic or having understood its risk-return nature?

(16) What type of margins did the exporters have and how much of it was given away or hedged?

(17) If it was a custom-made contract, was exiting possible before maturity? If so what was the additional cost burden?

(18) Were the hedging products used by the bankers thinly traded?

(19) Finally, how effective were the hedging tools used in the Indian financial market. Alternatively, could these companies have hedged their risk outside the country?

Thus, before putting the blame squarely on the bankers, the replies of the Tirupur exporters will reveal to what extent they understood these exotic products before buying them. If their reply was “we trusted the banks to protect us” they need to be told that there is no free lunch.

Painful as it is, it happens all the time in the corporate world and the only way to eliminate it is to embark on a knowledge campaign and training for all the exporters to protect them from such events.

Bobby Srinivasan G. Balasubramanian Faculty Members IFMR, Chennai

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